As mentioned in the last section, in private equity deals, the GP (project Sponsor and Organiser) will take a higher share of the profits if the project is highly profitable, and a lower share for lower levels of profitability. The example of a profit share shown in the last section was based on distributing the absolute ($ amount) of profit in each year according to some percentages for each party, where the size of each band was also determined in absolute ($ amount) figures.
In practice, the size of the bands which determine the share split to apply (i.e. to split profits between the GP and LPs) is related to the amount of $ capital (equity) and a return requirement or expectation. Thus, the bands are calculated in each period based on the (notional) capital present at the beginning of the period, given a return assumption. The principles behind the formulas to calculate the split of the cash payout in each period are the same as discussed earlier. The additional complexity is that the size of the bands changes each period, as the upper limit for each band is determined by adding:
- The capital balance at the start of the period.
- The return hurdle (applied to the starting capital balance).
- Any new capital injections made in the period.
Once the upper limit to the payout in the band is established, the payout is made up to this amount as long as sufficient cash flow is available. (Otherwise payment is made only up to the amount of available cash flow). Then, the ending balance for the capital is calculated, and this is brought forward to the next period.